News and a Primer for the Small Investor and Mutual Fund Owner
If you are the manager of a “hedge fund” be worried, be very worried. If you have invested in hedge funds that seek continuous annual returns greater than 15% on your investments then you should be worried. But for the overwhelming majority of small investors, the current slump in the market is temporary and should not be a major concern.
Hedge funds are private investment groups that are not subject to the government regulation that mutual fund companies must follow. They are involved in a variety of investments that attempt to leverage their money and thus exert more control over markets than the actual real dollar amount of their investment. The intent is to produce exceptionally high returns for their investors. Essentially, “the greater the risk, the higher the reward” axiom is their guide. The term “hedge” means that they are attempting to cover the high risk associated with high reward by seeking other less volatile investments to cover a portion of the risky venture. In other words, they try to hedge their bets.
Unfortunately, many of these hedge fund managers have become increasingly risk prone and have failed to sufficiently “hedge” their investments as they seek high returns. Many have invested in what is called the sub-prime lending market. Essentially, sub-prime lending refers to making loans to customers that have much less than a stellar line of credit. These customers are forced to borrow and pay a higher interest rate than most solid borrowers. Hence the return on a loan is higher.
Currently, attention is focused on the down-turn in the real estate market in the US. Real estate values has been enjoying unprecedented growth over the last decade and return to more normal annual increases in value have been long overdue. Here is where the the forces of the market have collided.
With hedge funds using the sub-prime lending markets as their way of increasing profit and in many instances using that same market as their “hedge” against other risky investments, one can see the dilemma that these managers are facing. To oversimplify, one morning a hedge fund manager awoke to discover that the fund might be way overextended in the risk category and began to get nervous. Since over a third of hedge fund managers work out of New York, one can easily imagine how this nervousness multiplied and has now spread. However, this nervousness and the subsequent sell offs are really the result of the forces applied by a group of investors that wield more power than their actual investments should convey on them. While hedge funds control hundreds of billions of dollars, in the overall scheme of financial markets this is actually much less that 1% of the investment dollars that are available.
While much of the Wall Street crowd claim to be independent thinkers, the reality is that they follow a crowd mentality. In the not too distant future someone will wake up and discover that the market is undervalued and begin the cycle that will result in an upturn. Companies are not going out of business, products are being produced and consumers throughout the world are still buying. The American economy is flourishing, unemployment is at historic lows and in spite of the on-going war on terror life in America goes on as usual.
Real estate valuations will adjust and the only real losers will be those that purchased property within the last year. Others may notice a decline in value from last year, but overall long term growth in value will be realized.
The bottom line is that the small investor and mutual fund holder should not be overly concerned. The Wall Street traders have exerted significant influence over the last several weeks, but the markets are sound and the small investor just needs to remain a player and watch the market forces that will eventually stabilize the stock market in the long term.